Deposit return scheme for Scotland: full business case stage 1

2018/19 forecast outturn

Cost assumptions have been developed in 2018/19 which are escalated to the commencement of the scheme.

Ten years (2019/20 to 2028/29 inclusive)

The financial model has been developed over a ten-year annual basis whereby Year 0 (2019/2020) reflects the year directly before the scheme is launched and Years 1-9 reflect the forecast financial position of the Scheme Administrator following launch on 1 April 2020. It should be noted that the date of scheme launch is a modelling assumption used to undertake the investment appraisal and may in practice vary in accordance with ministerial approval and business and implementation planning.

The rationale for modelling one year prior to scheme launch is to reflect the revenues and expenses expected to be incurred by the Scheme Administrator in establishing the scheme to correctly reflect affordability.

The revenue and cost base modelled across Year 0 to Year 1 reflects a start-up period where variability is expected in revenues and costs as the Scheme Administrator becomes established and operations achieve a steady state (modelled from Year 6 to Year 9). In the start-up phase, scheme revenues are heavily driven by the producer fee and sale of materials revenue whilst costs ramp-up as capital investment activity occurs and operational functions are established and reach an efficient run rate.

As outlined in Cash Inflows/Outflows below, Year 6 to Year 9 is considered the true reflection of steady state operations as up to this point, the Scheme Administrator will not recognise all available cash as revenue on the profit and loss account. Over the course of Year 0 to Year 5, referred to as the Observatory Period, the Scheme Administrator will be collecting evidence on consumer behaviour to support the establishment of an assumption that reflects the amount of deposits that are never to be redeemed in a given period, and therefore can be recognised as revenue.

20p

Under the preferred scheme design, the deposit level is set at 20p. It is assumed to be constant across the entire modelled period and therefore drops in value in real terms as a result of inflation.

90%

Under the preferred scheme design, the annual target recycling rate is set at 90%. That is, it is assumed that of all eligible DRS material in the scheme, 90% will be returned and a 20p deposit redeemed.

The model applies a ramp-up assumption to demonstrate performance against the target in the initial years of the scheme.

Deposits in/ Deposits out

As outlined in the Commercial Case, the treatment of the deposits has been modelled based on the Norwegian DRS scheme. A key factor of this scheme is that the Scheme Administrator is treated as operating in a principal capacity in respect of deposit inflows and outflows, as compared to an agency capacity. The difference is that as a principal the Scheme Administrator will recognise the deposits as revenue and expenditure in its profit and loss account, whereas an agent would be responsible for managing the collection and disbursement of the deposits, but they would not be recognised as revenue and expenditure in the profit and loss account.

The rationale for the principal capacity is that there is a clear distinction of receipts in (Scheme Administrator and producers) and payments out (Scheme Administrator and retailers).

• Deposits In (Revenue) - Producers are required to provide a report to the Scheme Administrator at an agreed periodicity, typically monthly, outlining the number of containers that have been sold to wholesalers in this period. The Scheme Administrator will invoice the producers for the relevant amount based on the report.
• Deposits Out (Expenditure) - Retailers will in the first instance provide consumers with their deposit refund for redeemed DRS material. Following this event, they will invoice the Scheme Administrator at an agreed periodicity, for reimbursement of deposits paid.

In any given period, it is possible that the value of deposits paid into the Scheme Administrator may exceed the value of deposits that are redeemed. Based on the Norwegian DRS scheme (and DRS schemes in other jurisdictions), the Scheme Administrator is in principle able to recognise and, therefore, obtain the net benefit between the revenue and expenditure in relation to the deposits (referred to in this Financial Case as unredeemed deposits). The unredeemed deposits can then be used to partially fund the scheme expenses.

See next section for the assumptions underpinning how and when unredeemed deposits can be recognised by the Scheme Administrator.

Unredeemed deposits

As outlined above, unredeemed deposits arise where a deposit has been paid to the Scheme Administrator by the producer on an eligible container, but the container has not been (and will not be) returned to a retailer by a consumer and, therefore, the deposit value is not paid out of the scheme.

Under this circumstance, the Scheme Administrator is (subject to the appropriate sign-off from their external auditor) able to recognise the net benefit as 20p per unredeemed container per period.

In practice, the Scheme Administrator will need to make a determination on the following two elements in order to ascertain the total net benefit from unredeemed deposits:

1. The volume of deposits that will be classified as unredeemed deposits and therefore can be used to offset scheme expenses

2. The timing from which the Scheme Administrator can provide sufficient evidence to allow audit sign-off for the recognition of the unredeemed deposits in the profit and loss account.

In respect of Item 1, the Scheme Administrator will need to collect evidence of the volume of deposits that are not redeemed over a sufficient period of time in order to develop a commercial assumption on the appropriate amount to be deemed 'unredeemable'.

For modelling purposes, the value of unredeemed deposit revenue is calculated as 20p multiplied by the volume of unredeemed containers per period derived in correlation to the target recycling rate i.e. where the TRR is 90%, the number of unredeemed containers is expected to be 10% of all containers in the DRS.

In respect of Item 2, the sufficient period of time over which this assessment should be made will be a matter for justification by the Scheme Administrator based on the quality and volume of evidence that is collected. For modelling purposes, it is assumed that a five-year Observatory Period will be required to enable the development of the evidence base to satisfy auditors. Unredeemed deposits will therefore be recognised from Year 6 to Year 9 (the steady state period) in the profit and loss account.

Sale of material

The Scheme Administrator has the ability to sell eligible DRS material that has been returned through the scheme. The modelling assumes that 97% of eligible DRS material that is returned is sold.

100% of returned material is not assumed to be saleable based on consultation with existing schemes in other jurisdictions who have indicated that approximately 2-3% of material may be damaged or not of saleable quality as it passes through the supply chain i.e. glass bottles may be broken during sorting.

The model applies a £/tonne rate to the volume of returned material to calculate the total revenue. The rate assumptions are applied at a material level i.e. PET, aluminium/steel, glass (flint), glass (brown) and glass (green) to accurately reflect the relativity of market rates. Whilst it is acknowledged that aluminium and steel prices vary in the market, the two materials have been aggregated in the financial modelling and a revenue rate closer to market rates for aluminium has been adopted as steel material comprises only 1% of the forecast volume.

The £/tonne rate per material is outlined below:

The rates adopted for modelling purposes are based on a survey of spot rates available for each material type.

The model also has the ability to apply a sensitivity to the relevant rates to reflect the volatility of material prices in both domestic and international markets.

Producer fee

As a result of the Extended Producer Responsibility (EPR) nature of the scheme, the onus is on producers of the eligible DRS material to support the efficient establishment (including set-up costs) and financial management of the scheme. The producer fee, which is recognised by the Scheme Administrator as revenue, is set on a cost-recovery basis. The fee will vary but is calculated each period (in practice, monthly) and should offset all scheme expenses not recovered by other revenue streams. This includes direct operating costs and debt service required to fund upfront capital.

Based on the current forecast, the following contributions are required from producers across the start-up and steady state operations of the scheme:

1. Start-up period (Year 0 to Year 5) - Producer fee 3.3p per container, or on average £51 million a year, as a result of being unable to recognise the benefit of 'never to be redeemed' deposits until Year 6

2. Steady-state period (Year 6 to Year 9) - Producer fee 1.5p per container, or on average £30 million a year

Other

The Scheme Administrator will also be able to generate revenue through interest earned on cash balances which is assumed at a rate of 1% per annum.

Workforce

Workforce costs comprise a lean workforce required to execute the functions of the Scheme Administrator and a workforce to operate the counting and bulking centre facilities.

Following establishment of the scheme, the workforce costs for both system administration and counting and bulking centre operation equate to an average of £3.2 million a year.

The workforce cost has been determined based on a high-level assessment of staffing requirements based on consultation with existing schemes in other jurisdictions.

Property

The economic modelling has indicated that the supply of throughput in the scheme could be managed by the establishment of counting centres which comprise both a bulking point and counting apparatus at each facility. This assumption has been adopted for financial modelling. However, in practice the requirement and timing will be determined by the Scheme Administrator based on property availability and suitability to support the functions of the DRS.

Properties are assumed to be acquired in Year 0 where construction of each facility is then completed before commencement of the scheme in Year 1.

Properties and related equipment are depreciated on a straight-line basis for the term of their respective useful life as outlined below:

Buildings - 25 years

Counting apparatus - seven years

Technology - three years

See Capital and Revenue Requirements for further details.

Logistics

As currently modelled, logistics costs in the steady state period reflect approximately 21% of direct operating expenses.

A logistics contract is expected to be entered into for the provision of pickup and delivery services from material return points across the network i.e. pickup from retailers and delivery to the relevant counting centre facility.

The costs are forecast by applying an estimated £/tonne rate multiplied by the relevant volume of returned material. Two rates are used to distinguish material that is collected from an automatic return point i.e. (i) material that is compacted through an RVM or (ii) a manual return point where material is collected and stored manually prior to pick-up. It is assumed that 85% of all material is collected through an automatic return point whilst 15% is manually handled.

As a result, the financial modelling forecasts an average logistics fee of £16.5 million a year in steady state, comprising the following breakdown:

Automatic handling - £12.9 million a year.

Manual handling - £3.6 million a year.

The rates underpinning the forecast are pre-commercial negotiations and do not assume any route optimisation factors and as a result may vary upon detailed consultation and negotiation with suppliers.

Cost of fraud

Evidence from established jurisdictions indicates that a level of fraud should be anticipated within the scheme.

The fraud can occur in a number of ways. Some examples include:

1. Ineligible materials are accepted manually by retailers and deposits are paid. However, material is ineligible for sale and/or potentially contaminates eligible sale material.

2. Ineligible materials are accepted through the automatic RVM and deposits are paid. However, material is ineligible for sale and/or potentially contaminates eligible sale material.

3. Illegally manipulating/tampering with RVMs to claim additional deposits for the same material.

Ineligible materials can be containers trafficked from outside the jurisdiction of the scheme, or alternatively, locally-produced containers that are made of material that is not included within the remit of scheme i.e. HDPE.

The financial implications of the various types of fraud can include a decrease in unredeemed deposits revenue, a decrease in sale of materials revenue and potentially an increase in handling fees due to the introduction of additional material into the DRS eco-system.

The model assumes that, in most instances, the risk of this expense sits with the Scheme Administrator and as a result adopts an expense factor associated with fraudulent behaviour as 20p multiplied by 1.5% of the number of containers. 1.5% has been adopted based on the experience of existing schemes in other jurisdictions.

While it is anticipated that fraudulent activity will be monitored and managed by the Scheme Administrator and the related regulatory framework, the model holds this assumption constant across the modelled period.

Communications

It is recognised that a critical success factor to achieving the scheme's objectives is effective communication across various groups of stakeholders including producers, retailers and consumers.

As a result, the Financial Case provides an upfront allowance for communications expenditure equating to £1 million in Year 0 which modulates to approximately £400k a year upon scheme commencement.

Handling fee

As currently modelled, the handling fee in the steady state period is on average £50.6 million a year and reflects the largest scheme expense at approximately 65% of the direct operating cost base.

The handling fee intends to compensate retailers for their role in accepting and storing returned material until it is collected by the scheme logistics partner. The handling fee will vary depending on whether the retailer manually processes and stores material or automatically does this through the use of an RVM.

Under the preferred scheme design, four types of return points are modelled^[53]:

Return Point 1 - Return to Hospitality Restaurants and Cafes (HoReCa) - Closed loop (manual handling)

Return Point 2 - Return to HoReCa - Open loop (manual handling)

Return Point 3 - Return to Retail (automatic handling)

Return Point 4 - Return to Retail (manual handling)

The handling fee is calculated by forecasting the costs expected to be incurred by retailers in accepting and storing returned material, and considers this cost against the forecast of material expected to flow through the particular return point, to calculate a £/container rate that is then multiplied by the total material.

The cost base that forms the numerator in the above methodology will vary for manual vs automatic handling processes. For example, the handling fee for Return Point 3 will be calculated by estimating the establishment and run costs of installing an RVM(s), in addition to compensating the retailer for the value of lost retail space and lost staff time.

The average handling fee a year is estimated as follows:

Automatic handling return point (Return Point 3): 3.1p/container

Manual handling return points (weighted average across Return Points 1, 2 and 4): 1.5p/container

Not for profit (NFP)

The model is developed in accordance with the Commercial Case that identified a not-for-profit corporate structure as the preferred delivery route.

Private sector

The Scheme Administrator is expected to comprise various private sector participants that are likely to establish a Special Purpose Vehicle (SPV)/Independent entity to execute the objectives of the scheme.

The key financial implications are:

1. Debt is expected to be financed at commercial rates

2. There are no affordability/public sector budget implications

Corporation Tax

The vehicle is expected to be exempt from Corporation Tax as a result of the not-for-profit status.

VAT

The goods and services administered by the scheme are expected to be exempt from VAT as a result of the not-for-profit status.

Other

PAYE tax and National Insurance contributions are estimated at 20% of the salary cost base and have been built into and reflected in the workforce cost estimates.

Counting centre buildings and equipment

An upfront capital investment of approximately £27.6 million is required in order to fund the acquisition and establishment of counting centre facilities.

The capital investment comprises three asset classes which are considered within the forecast:

Asset Class 1 - Counting centre buildings (useful life: 25 years)

Asset Class 2 - Counting centre apparatus (useful life: 7 years)

Asset Class 3 - Scheme administrator equipment (software) (useful life: 3 years)

Replacement capital expenditure of approximately £7.5 million is expected in Year 8 of the operating scheme in order to replace the counting centre apparatus at each facility which has a useful life of seven years (Asset Class 2). This is expected to be funded through available cash balances.

A replacement of scheme administration software is not anticipated as a capital investment in the modelled period.

The upfront capital investment is expected to be 100% debt-financed at a commercial rate of 2% (see Capital and Financing for further details) whilst replacement capital expenditure is expected to be funded through available cash balances.

All assets created are assumed to be recognised on the balance sheet of the Scheme Administrator and be depreciated over their useful life in accordance with the straight-line depreciation method.

It is assumed that retailers operating automatic return points will self-fund the acquisition/lease of RVMs used in compliance with their obligations under the scheme. As such, no capital investment is required by the Scheme Administrator for this equipment.

Debtor days

Creditor days

30 days

£20.9 million

For the purposes of modelling, it has been assumed that industrial facilities will be required with a combined function of bulking and counting of material.

Reflecting a conservative case, it has been assumed that the Scheme Administrator will purchase all facilities upfront and manage them, directly.

In practice, the Scheme Administrator may be able to reduce the upfront capital investment by staggering the acquisition of these facilities as scheme operations ramp up and surplus cash funds are available or, alternatively, lease these facilities or pay a network operator fee depending on availability and suitability of infrastructure across the Scottish network. The associated costs of alternative options will be considered in further detail during the business planning phase.

£6.4 million

Each facility will be fitted out with counting and sorting machines. As a result, the estimated cost per facility is £1.6 million.

This equipment is expected to be replaced following the end of its useful life of seven years at an increased cost of £7.5 million reflecting inflation of 2%.

Similar to above, there may be alternative options for mitigating part or all of the upfront capital investment requirements through leasing equipment or paying a network operator fee. The associated costs of alternative options will be considered in further detail during the business planning phase.

£0.3 million

It is expected that £0.3 million of upfront capital expenditure will be required to establish the Scheme Administrator's IT infrastructure.

£27.6 million

£20.9 million

It is assumed that the private sector participants in the industry-based group will comprise beverage and retail industry members.

As a result, a proxy of the assumed cost of capital that could be accessed by these participants in the commercial borrowing sector has been adopted.

This all-in cost of capital rate is 2% a year and is assumed to be secured against the assets of the scheme.

As identified above there may be alternative options for either reducing the upfront capital investment requirement (staggering of investment) or financing through alternative means (leasing, producer loan, and cash surpluses) and these will be considered further in the FBC Stage 2.

£0.3 million

£6.4 million

£27.6 million

£78.2 million

£0.8 million

On average, workforce costs for the administration of the scheme are estimated at £790,000 a year. These costs comprise the personnel required to undertake the management and administrative functions of the scheme. However, it does not include the operational workforce required in the counting centres (see below).

Whilst the mix of employees will be assigned during the business planning phase, the cost base assumes a 20% allowance for tax and National Insurance contributions across the workforce.

50% of this cost base is assumed to arise in Year 0 where recruitment of key personnel will be required to support the establishment of the scheme prior to launch in Year 1.

£2.5 million

The workforce employed across four counting centres is estimated to cost on average £2.5 million a year. Based on a high-level assessment of workforce requirements as informed by consultation with existing schemes in other jurisdictions, the workforce is expected to comprise supervisory and management staff, counting and sorting machinery specific staff, administrative and general facility staff and other technical staff.

Whilst the mix of employees responsible for scheme administration and counting centre management and operation will be assigned during the business planning phase, each cost base assumes a 20% allowance for tax and National Insurance contributions across the workforce.

50% of this cost base is also assumed to arise in Year 0 where recruitment of key personnel will be required to support the establishment of the facilities prior to launch in Year 1 which will ramp up to full capacity in Year 1.

£0.5 million

On average, ongoing operational costs of the Scheme Administrator are estimated at £500,000 a year.

A detailed breakdown of the items assumed in this cost base can be found in the Socio-Economic Case. However, broadly the costs comprise general running expenses of the office facilities including rental, utilities and supplies.

£1.2 million

Ongoing operational costs for the total number of counting centre facilities is estimated at an average of £1.2 million a year. Assuming an equivalent capacity and fit-out of each counting centre, this results in an average spend of approximately £300,000 a year per counting centre.

This cost base comprises rental, utilities, supplies, cleaning and other ongoing costs.

£16.5 million

The logistics cost is derived by multiplying the volume of material in tonnes expected to flow through each of the return point configurations by a respective £/tonne rate. There are two rate variations based on whether material has been collected through an automatic return point or manual return point. The breakdown of the average annual logistics fee under steady state is as follows:

a) Logistics fee for collection of manually handled material (£3.6 million a year)

b) Logistics fee for collection of automatically compacted material (£12.9 million a year)

Based on discussions with existing schemes in other jurisdictions, it is assumed that 85% of material that is collected flows through an automatic return point whilst only 15% is collected from return points where material is manually handled and stored.

£0.5 million

Communications and marketing are expected to be a recurrent expense for the Scheme Administrator in order to support successful scheme implementation.

In Year 0, the communications expenses is estimated at £1 million to support development and delivery of educational material for initial circulation. However, the average cost of communications from Year 1 onwards is estimated to be £460,000 a year, reflecting a typical annual marketing cycle.

£5.3 million

The inclusion of an expense reflecting the cost of fraud is a conservative tool to understand the sensitivity of the scheme to the loss of revenue due to fraudulent behaviour.

The cost methodology has been derived through consultation with other existing schemes which have advised that 1.5% of total deposits received is an indicative cost of fraud allowance. While it is difficult to predict if and how the Scottish scheme will experience similar levels of fraudulent behaviour as other jurisdictions, the scheme appears to be recurrently affordable despite the inclusion of this expense.

In practice, it is expected that this allowance will vary and reduce from period to period as the Scheme Administrator will be responsible for actively monitoring and addressing fraudulent behaviour.

£0.3 million

An average cost of £250,000 a year is estimated to reflect the regulatory compliance fee paid by the Scheme Administrator to the new regulatory body.

An original estimate was provided during the development of the OBC which has been escalated based on the development of the scheme design and the application of inflation at 2%.

£2.2m

£1.8 million

Depreciation is modelled on a straight-line basis on an initial capital investment of £27.6 million.

The breakdown of the average depreciation forecast across the three asset classes outlined in section 4.3 is as follows:

Asset Class 1 (buildings) - £0.8 million (useful life: 25 years)

Asset Class 2 (equipment) - £0.9 million (useful life: 7 years)

Asset Class 3 (software) - £0.1 million (useful life: 3 years)

£0.4 million

The average interest expense of £422,000 a year is calculated on the balance of the initial capital investment of £27.6 million which is assumed to be 100% commercially debt-financed at a rate of 2%, repayable over a ten-year term.

Cost of capital assumptions are outlined in section 3.4.3.

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£80.8 million

£33.9 million

At 42% of the revenue base under steady state operations, unredeemed deposit revenue reflects the Scheme Administrator's largest source of revenue, once recognised.

Under the preferred scheme design, unredeemed deposits revenue is calculated as 10% of the total volume of DRS material multiplied by the deposit rate of 20p per unredeemed container per period.

In accordance with the treatment of deposit inflows and outflows, under the Norwegian scheme, the DRS Scheme Administrator is only able to recognise the net benefit of these scheme inflows/outflows as revenue on the profit and loss account once a sufficient base of evidence has been established to demonstrate the volume of containers deemed to be 'unredeemed' is reasonable, and this is approved by the Scheme Administrator's external auditor.

For the purposes of modelling, it is assumed that a five-year observatory period will be sufficient to collate the base of evidence required and, therefore, the net benefit of deposits paid by producers and deposits paid to retailers is able to be recognised from Year 6 onwards.

See Impact on Profit & Loss Account below for further detail.

£20.9 million

Sale of materials revenue is derived once returned DRS material received by the Scheme Administrator is sold onwards to relevant material markets.

This revenue source is sensitive to the volatility of material markets and external prices. However, the model assumes the following rates which are based on a survey of market rates available in each material market:

The breakdown of total sale of materials revenue by material type is outlined below. The table demonstrates that aluminium (99% of volume) and steel (1% of volume) containers contribute significantly to this revenue representing more than 70% of the revenue base.

The average volume of materials by type is outlined in the table below:

*99% Aluminium

£25.9 million

As outlined in section 3.3, Extended Producer Responsibility places the onus on producers of eligible DRS material to support the efficient establishment and financial management of the scheme.

As a result, the producer fee, which is recognised by the Scheme Administrator as revenue, is set on a cost-recovery basis and is intended to offset all operational expenses associated with the scheme including debt service.

During the observatory period (Year 0 to Year 5) where the Scheme Administrator is not recognising the net benefit of unredeemed deposit revenue, the producer fee at £48.4 million a year is significantly higher than the contribution required under steady state operations (Year 6 to Year 9).

Given the cost base outlined in section 3.4, the producer fee is calculated as an average of £25.9 million a year under steady state operations.

While the producer fee is likely to vary period to period in practice, the methodology adopted in the model is consistent with existing schemes in other jurisdictions and upholds the cost-recovery principle.

On a container basis, the average annual contribution required by producers is calculated as 3.3p per container during the observatory period and reduces to 1.5p per container once steady state operations are achieved.

During the business planning phase, further information will be gathered in respect of the processing costs per material in order to derive a producer fee by material type.

The handling fee reflects the largest driver within the Scheme Administrator's cost base, approximately, 65%. The sensitivity takes the calculated handling fee across all return points and increases this amount by 10%. The handling fee will be subject to negotiation and commercial discussions with retailers.

On average, £48.4 million per year

On average, £53.2 million per year

£25.8 million per year.

(1.6p/ct)

Increase by 19%

The volume of DRS material that flows through each return point impacts the logistics cost and handling fee cost elements.

85% Return Point 3

15% Return Points 1,2 and 4

90% Return Point 3

10% Return Points 1,2 and 4

£21.2 million per year

(1.4p/ct)

Decrease by 17%

Each sale of material £/tonne rate is applied to its respective volume of material to calculate forecast revenue. Sale of materials rates can be subject to price volatility in international/ domestic markets for each material type.

PET - £200/tonne

Aluminium and steel - £1,300/ tonne

Glass (flint) - £17/tonne

Glass (green) - £6/tonne

Glass (brown) - £12/tonne

PET - £180/tonne

Aluminium and steel - £1,170/ tonne

Glass (flint) - £15/tonne

Glass (green) - £5.6/tonne

Glass (brown) - £11/tonne

£23.3 million per year

(1.5p /ct)

Increase by 8.0 %

Each logistics £/tonne rate is applied to the respective volume of material that is forecast to be collected through the relevant return point channel i.e. 85% of material is expected to be handled through an automatic return point, whilst 15% is expected to be handled through a manual return point.

Logistics fee for automatic handling - £95/tonne

Logistics fee for manual handling - £150/tonne

Logistics fee for automatic handling - £105/tonne

Logistics fee for manual handling - £165/tonne

£24.7 million per year

(1.6p/ct)

Increase by 14.4%